Larry Snoddon can barely contain his elation as he plans to sail across the Atlantic this spring. After all, Snoddon already has the wind in his sails with the 51% return he made last year on a $3.8 million investment in a commodity futures fund. A former CEO of public-relations firm Burston-Marsteller, now retired, Snoddon was glad he had parked 20% of his portfolio in a Marathon Capital fund, considering how poorly his other investments in the stock and bond markets fared. "Futures saved the day," he says.
Indeed, many commodity futures funds flourished last year, posting returns as high as 181% (table). Overall, the Managed Account Reports (MAR) index, which tracks these funds, rose 6.1%, a far cry from the bloodied stock market indices. While Hanseatic Group, which posted last year's highest return, profited by betting against stock indices, others thrived by capitalizing on the gains made by energy and currency futures. "Last year, the moves in natural gas, crude oil, and heating oil were huge. That's where we made a lot of our money," says Bruce Terry, managing director of Marathon Capital Growth Partners of Westport, Conn. This year, Terry is keeping a close watch on yen and grain contracts.
You don't have to be a millionaire to participate in these kinds of funds anymore. While some still want minimums of $25,000 to $1 million, investors with a net worth of $150,000 can get into public managed futures funds through such firms as Salomon Smith Barney (C), Morgan Stanley (MWD), and Merrill Lynch (MER). The minimums usually start at $5,000, but drop as low as $2,000 if you have an individual retirement account.
The fees, though, on these funds are high. The funds generally charge an ongoing management fee of 2%, and they take 20% of any profits. Brokers also collect trading commissions that are passed along to investors. They range from 2% to 6%, depending on how often the portfolio manager trades.
Even advocates of these funds don't believe everyone can stomach them. Experts say an investor has to be willing to take losses of as much as 15% in any given year. They're especially gut-wrenching during years of calm and low inflation, as in 1999, when most futures funds had double-digit declines. "There can be extended periods of flat performance, which are often followed by bursts of profitability," says John O'Hara, managing director of investment management at Goldman Sachs & Co. Those who decide to participate in futures funds should put only 5% to 10% of their investable assets in them, advises Bob Murray, senior vice-president for managed futures at Morgan Stanley Dean Witter.
The allure of commodity funds is that they invest in a wide array of futures contracts, ranging from interest rates and currencies to the ubiquitous grains. They're also spread across the globe, so all told they bear little correlation to the U.S. stock market.
Financial advisers say futures are a good hedge against sudden downturns in the economy. That's because such events usually cause interest-rate or currency futures to make large, protracted moves, allowing futures fund managers to profit hugely. Futures funds can profit when futures prices move up or down because traders can bet either on rising or falling prices. In contrast, few mutual funds can even sell short, and those that can are limited.
Wealthy investors like Snoddon can invest directly by opening accounts with a fund manager, or, in industry parlance, commodity trading adviser. "But they have to be careful because of the margin requirements," says Thomas Schneeweis, finance professor at the University of Massachusetts at Amherst. For example, you can buy a futures contract worth $100,000 with only $10,000. But if the contract loses, say, 20%, you would have to pony up an additional $10,000.
That's the reason many wealthy investors avoid direct investment in futures and opt instead for the funds. Individual investors become limited partners in a fund, while the brokerage firm or fund sponsor serves as the general partner that is liable for any margin calls.
Another approach to futures is the fund-of-funds arrangement. These funds allocate their money among several other futures funds, selected according to such factors as risk and diversification. "We try to get a blend of managers with different trading styles and offer diversification within managed futures," says Morgan Stanley's Murray.
Historically, when the stock markets have been pummeled, the commodity funds have done well. For example, during the Russian debt crisis in August, 1998, U.S. stocks dropped 15%, but the average futures fund was up 6%. There were similar movements during the stock market crash of 1987, and the Persian Gulf war. Overall, the average yearly returns from futures funds fall in the mid-teens. But that doesn't mean there's a regular 1% to 1.5% return every month. Those results come in quick bursts of performance.
COMEBACK. Commodity futures fund investors were greatly rewarded during last year's fourth quarter. While the stock market struggled, the MAR index climbed 11.7%. "They did have a long 18-month losing streak, but the futures investments made it back when investors needed it the most," says David Vogel, head of managed futures at Salomon Smith Barney.
Another reason these funds offer protection from the stock and bond markets is the odd pattern of investment. Most of the futures managers trade on the basis of technical, rather than fundamental, analysis, looking at such measures as price movements and changes in trading volume. They have developed analytical models based on the behavior of different futures markets over the years. "It's a systematic approach, and the systems are designed to profit when the futures products move through certain designated levels," says Sol Waksman, president of Barclay Trading Group, which researches and tracks futures funds.
Although your predominant investments should still be in stocks and bonds, commodity futures funds offer a good means of diversification, Schneeweis says. After all, they've made money in 17 of the past 20 years. Indeed, as long as you can stand the gyrations, putting a small part of your portfolio in these funds can't hurt. And during sudden downward spirals in the stock market, such as we had last year, they could actually prove to be a saving grace. By Pallavi Gogoi